SAS No. 59 requires auditors to evaluate the adequacy and feasibility of management’s plans to mitigate financial distress. The results of this study show that industry specialization improves auditors’ ability to more accurately evaluate management’s initiatives and the likelihood of going-concern issues. Though BRA methodology was not shown to improve reporting accuracy, the implementation of the methodology was limited to only two firms at the time of the study. This study suggests the importance of auditor specialization in improving reporting accuracy which can impact the approach audit clients take in obtaining an auditor.

For more information on this study, please contact Liesbeth Bruynseels.

Since auditors are required to evaluate the adequacy of management plans to mitigate financial distress, when bankruptcies occur that were not preceded by a going-concern report, the audit report is perceived to lack quality. This study investigates whether enhanced industry knowledge (auditor specialization) or an increased focus on business risk auditing methodologies improves audit-reporting accuracy. These are the two areas of focus because:

A new audit approach defined as “business risk auditing” (BRA) forces an auditor to determine whether the client’s strategic objectives are being met and to assess the likelihood of going-concern issues. BRA is embedded in international auditing standards (ISA 315) and proposed standards by the PCAOB to require the auditor to assess a client’s business environment and risks in the audit. Recent studies have shown that BRA can lead to more efficient and effective audits.

Recent research has also indicated that information obtained about the client’s strategic plans to mitigate financial distress can have a significant impact on the likelihood that an auditor will issue a going-concern report. Therefore, this paper examines the impact of auditor specialization and auditor risk methodology on audit-reporting accuracy in the setting of financially distressed firms in which managers take initiatives to reduce this distress.

Design/Method/ Approach:

The data consists of U.S. public companies from manufacturing industries that declared bankruptcy between 1999-2002.

Auditor specialization is measured based on audit firm market share within a particular industry.

Two of the Big 5 firms in the study implemented the BRA methodology. Therefore, only audits conducted by these two firms are considered to have employed BRA methodology.

The authors also report if a company in the sample had a significant strategic or operating initiative reported in its 10-Ks as a sign of management’s actions to mitigate financial distress.

Findings:

For companies that subsequently declared bankruptcy:

Specialist auditors were more likely than non-specialists to issue a going-concern opinion even when management had undertaken strategic turnaround initiatives.

Audit firms that used a BRA methodology were less likely to issue a going-concern opinion if the client had undertaken operating initiatives to mitigate financial distress.

All auditors, irrespective of type, were less likely to issue a going-concern opinion when the client had plans to raise cash in the short-term.

Contrary to the authors’ expectations, the reporting accuracy of BRA auditors is reduced when a client implements short term operating initiatives to reduce financial distress. Specialist auditors correctly interpret the information contained in management’s strategic long-term initiatives and more accurately signal the potential for a future bankruptcy by issuing a going-concern report.